Investing 101

Investment Accounts

Traditional Individual Retirement Account (IRA)
An IRA account is an excellent way to plan and save for retirement. Contributions made into the account may be tax deductible and the earnings grow on a tax-deferred basis. Contributions made into the account are not fixed, allowing individuals to choose when they want to fund the account. Depending on qualifications, maximum contribution are limited on a yearly basis to $3,000 in 2002 phasing out to $5,000 by 2009. A Traditional IRA is not taxed until it is withdrawn from. This means that the owner can defer paying taxes until retirement; when he or she will most likely be in a lower tax bracket.

Catch up Provision
The catch up provision states that anyone reaching the age of 50 before the end of that tax year can make catch up contributions into an IRA set up that year.

Roth Individual Retirement Account (Roth IRA)
A Roth IRA is similar to a Traditional IRA in some ways, but posses a few different characteristics. The earnings for a Roth IRA accrue on a tax-free basis, as opposed to a tax-deferred basis. However, unlike the Traditional IRA the contributions made into the account are not tax deductible. There is no fixed contribution plan for a Roth IRA; the only restriction is that the maximum yearly contribution is the same as the Traditional IRA.

529 Plan (Qualified Tuition Plan)
The 529 Plan offers families and individuals numerous benefits that may be advantageous for anyone who is likely to be incurring college tuition costs. A parent, grandparent, any relative, or friend who wants to contribute to a beneficiary’s future higher education costs can establish an account. An individual can even open an account for them self. There is no income restriction for individuals who want to contribute to a 529 plan; however, if contributions exceed the educational expenses penalties are applied to the remaining fund. As a result one should be careful not to over fund the plan to avoid the applied penalties.

Education Savings Account (ESA)
Similar to a 529 plan, the Education Savings Account (ESA) is an excellent means of saving for educational expenses. Contributions to an ESA accumulate earnings on a tax-deferred basis, and distributions used for qualified education expenses incurred at elementary, secondary, and post secondary educational institutions are tax and penalty free. The gains in an ESA are taxed at the account holder’s tax rate rather than that of the contributor, which is typically higher. This means that if a parent contributes to an account set up for their child, the tax rate applied to the account will be that of the child, not the parent. Contributors are not required to make deposits in the account every year, which allows for flexibility in funding the account. To be eligible to contribute to an ESA, the contributor’s modified adjusted gross income (MAGI) as figured on their income tax return must not be more than $110,000 for single filers and $220,000 for married individuals filing joint returns.
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Fixed Income

Preferred Stock:
Preferred stock is capital stock, which provides a specific dividend that is paid before any dividends are paid to common stock holders, and which takes precedence over common stock in the event of liquidation. Like common stock, preferred stocks represent partial ownership in a company, although preferred stock shareholders do not typically enjoy the voting rights of common stockholders. Similar to a bond, a preferred stock pays a fixed dividend that does not fluctuate. In general, there are four different types of preferred stock: cumulative preferred, non-cumulative, participating, and convertible.

Part of the above information was taken from the following website:

Cumulative Preferred Stock:
Cumulative preferred stock possesses a cumulative dividend payment. This means that the company must pay the preferred shareholders all dividends that were not paid in previous periods plus the dividend of the current period before the common stock shareholders can receive any dividend payments.

Non-Cumulative Preferred Stock:
Non-cumulative preferred stock does not possess a cumulative dividend. This means that dividend payments that were missed in previous periods do not have to be paid before the common shareholders receive dividend payments.

Participating Preferred Stock:
Participating preferred stock is preferred stock that gives the shareholder voting rights.

Convertible Preferred Stock:
Convertible preferred stock is preferred stock in which the holder has the option to convert the preferred shares into a pre-specified amount of common stock at anytime he/she wishes.

A bond is a loan given to an entity (business or government) in exchange for a fixed set of payments in the future. The fixed payments provide a haven for money during times of uncertainty in the market. Just like stocks, different bonds have different returns associated with their individual level of default risk. The higher the payments are the higher the risk associated with the entity. The characteristics of bonds are described in brief detail below as well as the different types of bonds.

Characteristics of a Bond

Face Value (Par Value): 
The amount the holder of the bond will receive on the last payment date. Usually bonds have a face value of $1,000, however mini-bonds have a face value of $500.

Coupon Rate: 
The amount, expressed as a percentage, paid annually to the holder of the bond. Payments are received semi-annually. The amount received annually is equal to the coupon rate multiplied by the face value.

Market Value:
This is the price the bond is worth on the open market. The price of a bond moves inversely to interest rates. As rates go up, the price of bonds decrease.

The maturity date is the future day on which the investor’s principal will be repaid. Maturities can range from as short as one day to as long as 30 years.

The yield of a bond is the return the holder receives on a bond. This is calculated by taking the coupon payment divided by the market price. Since yields are correlated to the price of a bond, when rates change, so does the yield. As price goes up yield goes down.

Yield to Maturity: 
YTM is a bit more complicated than the yield of a bond. YTM is the total return of a bond if the bond is held to its maturity. The YTM differs from the yield, as it not only takes into consideration the coupon rate, but also the face value of the bond that is received on its maturity date.

Bond Discount:
A bond issued at discount is sold below par value. For example a $1000 bond sold for $995. This is usually a result of high interest rates.

Bond Premium
A bond issued at premium is sold above par value. For example a $1000 bond sold for $1005. This is usually a result of low interest rates.

The issuer is the organization that is responsible for the payments of the bond.

Types of Bonds

Government issued bonds
These are classified by their maturity date and posses the lowest amount of risk to investors. In return giving a low coupon rate.

Treasury Bills Or T-Bills, have a maturity date of less than one year.
Treasury Notes Have maturity of less than 10 years
Treasury Bonds Have maturity of more than 10 years

Municipal Bond
A municipal bond is issued by a state, city, or local government. Municipalities issue bonds to raise capital for their day-to-day activities and for specific projects that they might be undertaking (usually pertaining to development of local infrastructure such as roads, sewerage, hospitals etc). Interest payments received from municipal bonds are generally exempt from federal tax. In the case that the bond is bought by a resident of the state that issued the bond, the interest payments are also exempt from state tax. Interest payments are further exempt from local tax if they are bought by residents of the locality that issued the bond. Capital gains however are taxable. Given the tax-savings they offer, municipal bonds are often bought by people who have large tax burdens. Yields on municipal bonds are often lower than corporate or Treasury bonds with comparable maturities, because of the important advantage of not being taxed at the federal level.
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Corporate Bonds
These are issued by corporations, usually to raise capital as an alternative to issuing additional equity. Corporate bonds usually have a par value of $1000 and they are taxable. The risk of a corporate bond varies based upon its grade. The risk of a corporate bond can range from slight risk comparable to government bonds to great risk.

Bond Rating Systems:
There is a bond rating system that is established by company analysts that assess the credit risk of companies. The higher the bond is graded, the less the risky the investment. Grades range from AAA to C or D, depending upon the rater. The lowest grade, C or D, are referred to as junk bonds. They possess a high risk of default due to financial instability within the company.

Convertible Bonds:
Convertible bonds have the option to be converted into a pre-specified amount of common stock.

Callable Bonds:
When a bond is callable it means that the issuer of the bond has the right to call the bond before its maturity date. In most cases when a bond is called, the principle will be repaid at a greater value than par

The chart below is the grading scale that has been developed by analysts to assess the credit risks of companies

Rating Scale Moody’s Standard
& Poor’s
Highest rating. Capacity to repay principal and interest judged high Aaa AAA
Very Strong. Only slightly less secure than the highest rating. Aa AA
Judged to be slightly more susceptible to adverse economic conditions A A
Adequate capacity to repay principal and interest. Slightly speculative. Baa BBB
Speculative. Significant chance that issuer could miss an interest payment Bb BB
Issuer has missed one or more interest or principal payments B B
No interest is being paid on the bond at this time Caa C
Issuer is in default. Payment of interest or principal is in arrears D D

Source: Dearborn Passtrak Series 7. General Securities Representatives, p44

Zero Coupon Bond
This type of bond possess’ no coupon payment but instead is issued at a great discount to its par value.

Ratio Analysis
Ratio analysis is a method used to assess the value of a company. All ratios can be constructed from companies’ financial statements. The ratio’s calculated can then be compared to companies within their industry, or market indices.

Liquidity Ratios

Current Ratio =  (Current Assets / Current Liabilities)
The current ratio is a measure of liquidity that defines a firm’s ability to meet current liabilities.

Quick Ratio = ((Current Assets – Inventory) / Current Liabilities)
The quick ratio is a measure of solvency, however it takes inventory into account because inventory is the least liquid of current assets.

Probability Ratios

Gross Margin = (Gross Profit / Sales)
The gross margin measures profitability on sales of the company while only considering cost of goods sold.

Net Profit Margin = (Net Income / Sales)
This measures total profitability of a firm when considering tax liability, operating expenses, and interest owed for debt financing.

Return on Assets = (Net Income / Total Assets)
ROA is a measure of a firm’s ability to use its resources (assets) to generate earnings.

Return on Equity = (Net Income / Owners Equity)
ROE is a measure of returns to stockholders. It is the firm’s ability to use its equity to generate earnings.

Turnover Ratios

Inventory Turnover (relevant to sales) = (Sales / Inventory)
Inventory turnover is a measure of how well a company manages its inventory and how effective a company is at generating cash flow.

Fixed asset turnover = (Sales / Fixed Assets)
This is a measure of management of assets and how well they use their resources to generate cash flow.

Asset turnover = (Sales / Total Assets)
This is a measure of management of assets. It shows how well the company can utilize total assets to generate cash flow.

Debt Ratios

Debt Ratio = (Total Liabilities / Total Assets)
Debt ratio measures how much of a company’s assets are financed by debt.

Fixed charge coverage = (EBIT / Interest + Leases + Preferential Dividends)
This is a measure of how effectively a company can pay off its fixed obligations.

Miscellaneous Ratios

Earnings per share = (Net Income / Shares Outstanding)
This shows how well a company can return investments and satisfy their shareholders. It essentially details how profitable a company is.

Dividends per share = (Dividends / Shares Outstanding)
This is how much in dividends is paid per each share of a company’s stock.

Price Earnings = (Price per share / Net Income)
Price Earnings is a measure of the stocks relative value.


PEG Ratio = (Price per share / Net Income)
Earnings growth rate


The PEG ratio is a measure of a stocks relative value in relation to its growth. A lower PEG ratio may indicate a greater value.

Financial Terms

Beta is the measure of a company’s systematic risk when compared to an index. The beta of an index is 1. If the beta of a company is 2 and compared to the S&P 500 then typically for every unit the S&P 500 increases the company will increase 2. Beta calculation is sensitive to the time periods used and the index it is measured against.

Standard Deviation:
On the average, how much a value deviates from its mean. When using a stock price, it measures the volatility of a stock. The higher the standard deviation, the more volatile the stock is.

Systemic Risk
Risk that affects an entire financial market or system, and not just specific participants. It is not possible to avoid systemic risk through diversification.
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Systematic Risk (also called market risk)
Risk which is common to an entire class of assets or liabilities. The value of investments may decline over a given time period simply because of economic changes or other events that impact large portions of the market. Asset allocation and diversification can protect against systematic risk because different portions of the market tend to under perform at different times.

Part of the above information was taken from the following website: